S Corp Requirements: What You Need to Qualify and Stay Compliant

S corporation status can bring some really valuable tax advantages to the table for small business owners. But those advantages also come with certain strings attached. For example, the IRS has strict rules in place as far as which businesses qualify in the first place, who can own them, and how the owner-employees need to be paid.

There are year-to-year criteria you’ll need to meet to maintain S corp status once you earn it, as well. In other words, there’s a lot more involved than simply filing a form and checking another box off your to-do list.

Generally speaking, S corp requirements fall into two categories:

• Eligibility rules you need to meet when pursuing the election in the first place
• Ongoing obligations you need to follow to keep the election

In this comprehensive guide, we’ll cover what small business owners need to know about both, including payroll, ownership, tax details, S corp filing requirements, and compliance maintenance.

What are the requirements to have an S Corp?

The basic eligibility requirements for S corp status come directly from the IRS. In order to qualify, a business needs to be a domestic corporation or other eligible domestic entity (e.g., an LLC that’s elected to be taxed as a corporation).

The IRS also places hard restrictions on who can own the business in the first place.

Shareholders generally need to be individuals, estates, qualifying tax-exempt organizations, or certain trusts. Partnerships, as well as most corporations, cannot be shareholders. The company in question also may not have any non-resident alien shareholders.

Some other essential S corporation requirements include the following:

• No more than 100 shareholders total. However, under the family aggregation rule in IRC § 1361(c)(1), members of the same family, a common ancestor, their lineal descendants, and spouses, can be treated as a single shareholder for purposes of the 100-shareholder count. This applies automatically; no separate election is needed.
• Only one class of stock. Differences in voting rights are disregarded for this test, but all outstanding shares generally need to confer identical rights to distributions and liquidation proceeds, determined by looking at the corporate charter, bylaws, state law, and any binding distribution or liquidation agreements.
• Proportional allocation. Income, losses, deductions, and credits associated with an S corp usually pass through to shareholders according to ownership interest.
• Eligible type of corporation. Under IRC § 1361(b)(2), insurance companies taxed under Subchapter L, financial institutions that use the reserve method of accounting for bad debts under Section 585 (generally banks and depository institutions), and current or former DISCs (Domestic International Sales Corporations) cannot elect S corp classification.
• Shareholder consent. Every shareholder whose consent is required must agree to an S corp election at the time Form 2553 is filed.

After you’ve completed your LLC formation and you’re electing S corp taxation, it must satisfy the same federal eligibility rules. For all intents and purposes, LLC members fulfill the same role shareholders would when it comes to formal election.

Ownership arrangements that seem perfectly routine under state law can mean problems for S corporation eligibility, so it’s advisable to have a qualified CPA or business attorney review your details before filing Form 2553.

S corp requirements for taxes

Once your election is in place, tax compliance officially becomes part of your annual routine. Here’s a rundown of the S corp filing requirements and key considerations to keep in mind:

Form 1120-S

Due on the 15^th day of the third month after the company’s tax year ends, Form 1120-S is the S corp-specific tax form to know. For calendar year S corps, that’s usually March 15^th, with a six month extension to September 15^th available when filed on time.

Schedule K-1

S corps must issue each shareholder a Schedule K-1 that shows that person’s share of income, credits, deductions, and other applicable tax details. They’ll need this when filing their personal income tax returns.

Estimated taxes

For federal income tax purposes, S corps are generally pass-through entities, so they don’t typically pay taxes on their business income. That income usually passes through the shareholders instead, so they may be required to make quarterly estimated tax payments throughout the year.

Please note that you can owe taxes on your share of S corp income even if you forgo distributions and leave the money in the business.

State filing requirements

Requirements can vary considerably from one state to the next, but many states do require separate S corp returns. They may also impose their own entity-level fees and taxes. For instance, California generally charges California S corporations a 1.5% tax on net income, plus an $800 minimum LLC franchise tax California.

Again, S corp tax returns can get extremely complicated very quickly, especially with multiple shareholders and state requirements to worry about. Professional tax preparation via a CPA is advisable.

S corp requirements for payroll

Payroll management is generally the part of the equation where new S corp owners fully realize that an election is about more than simply moving a few numbers around on a tax return.

To start with, the IRS expects you to receive reasonable compensation as an employee of your company before taking any non-wage distributions, meaning you can’t simply classify all your money as distributions to avoid employment income taxes. When an owner-employee hasn’t been properly compensated for their work, the IRS can (and will) reclassify payments as wages.

There’s really no one salary figure to shoot for when it comes to determining reasonable compensation. But common factors that affect it can include shareholder duties, responsibilities, experience, total time devoted to the business, and going standards as far as what similar companies pay for comparable work.

Any salary paid to an owner-employee is subject to the same requirements and withholding factors as other employee wages, including Social Security, Medicare taxes, and federal income tax. This means S corps with employees have certain filing obligations to fulfill, including:

• Form 941: Employer’s Quarterly Federal Tax Return, typically filed each quarter
• Form 940: Employer’s Annual Federal Unemployment (FUTA) Tax Return
• Form W-2: Issued annually to owner-employees and other employees for the purpose of reporting wages and applicable taxes

Businesses generally need an Employer Identification Number (EIN) to run payroll and may need to formally register with associated state tax and employment agencies. Staying compliant when it comes to how your company manages payroll can benefit from professional CPA or payroll provider assistance.

Ongoing compliance requirements

Meeting the initial requirements for S corporation status gets you through the door. But your business needs to stay in compliance to keep it:

• One class of stock: S corps need to maintain their single permitted stock class, as well as avoid any agreements that lead to impermissible differences in shareholders’ economic rights.
• Shareholder eligibility: S corporations also need to respect the 100-shareholder limit, as well as prevent shares from passing to ineligible shareholders. All changes involving investors, ownership transfers, or international shareholders should be subject to prior professional review.
• Annual corporate formalities: Depending on entity type and jurisdiction, these can include annual or biennial reports, registered-agent requirements, franchise taxes, minutes, resolutions, and appropriate record-keeping.

Failure to stay compliant with the specified requirements can result in termination of your S corp status. Plus, accidental termination of this status can carry major tax consequences. The business will revert to C corp taxation, potentially requiring a five-year wait before you can pursue reelection, per IRC § 1362(g). The five years run from the first day of the first tax year the termination took effect, and the IRS can grant earlier consent to re-elect in some circumstances, for instance, if more than 50% of the corporation’s stock is now owned by people who weren’t shareholders when the termination happened.

What happens if s corp requirements aren’t met?

Violating eligibility requirements can absolutely result in S corp election termination, possibly retroactively (going back to the date the violation occurred). Your company will also revert to C corp taxation. This can mean federal income tax at the corporate level, plus potential taxation of any dividends shareholders might receive. Your company will also typically have to wait five years before it will be eligible for election again.

If an election was terminated inadvertently, there is potential relief available. Under IRC § 1362(f), the IRS can treat an otherwise invalid or terminated election as continuing if all of the following are met:

• The IRS determines the circumstances causing the termination were inadvertent
• Steps were taken to fix the issue within a reasonable period after discovery
• The corporation and every person who was a shareholder during the relevant period agree to make any adjustments consistent with S corp treatment
  Relief under this provision is granted at the IRS’s discretion via a private letter ruling request, it isn’t automatic.

If you do feel you’ve identified a potential eligibility violation, don’t attempt to correct the situation on your own. Instead, contact a professional tax attorney or other qualified expert for assistance.

S corp requirements checklist

Need a way to review major requirements for electing and maintaining your S corp status at a glance? Refer to the following checklist:

Eligibility

• Business is an eligible domestic corporation or LLC
• Business has 100 or fewer shareholders
• Business has no nonresident alien shareholders
• Shareholders are eligible individuals, qualifying trusts, estates, or exempt organizations
• Business has only one permitted class of stock
• All required shareholders have consented to the election

Formation and election

• EIN obtained
• Form 2553 filed with the IRS by the applicable deadline
• Operating agreement, bylaws, or other governing documents reviewed for S corp compliance

Ongoing tax requirements

• Form 1120-S filed annually by the applicable deadline
• Schedule K-1 provided to each shareholder
• Shareholders make required quarterly estimated tax payments
• Applicable state S corporation returns filed

Ongoing payroll requirements

• Working shareholder-employees receive reasonable compensation
• Form 941 filed when required
• Form 940 filed when required
• W-2s provided to employees annually
• Applicable state payroll filings completed

Ongoing compliance requirements

• Required state annual or biennial reports filed
• Required corporate meetings held and records maintained
• Shareholder eligibility monitored when ownership changes
• One permissible class of stock maintained
• Registered agent and other state records kept current

Tailor Brands is here to help small business owners put crucial pieces of this foundation together, including by obtaining an EIN, managing S corp election, keeping your business in compliance after formation on your behalf, and more.

Conclusion

S corporation status brings multiple meaningful advantages into play for small businesses, but holding onto those advantages calls for ongoing attention. Missing routine filings can lead to headaches, but violating eligibility rules can put your entire S corp election into jeopardy, so ongoing compliance is key.

Never treat that compliance as a once-a-year concern to think about only during tax season. Professional CPAs can help manage ongoing payroll and tax obligations, while a business attorney can assist with shareholder arrangement reviews, airtight ownership changes, and so forth, making expert help a valuable way to stay ahead of the game.

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